Goldilocks

WEEK ENDING 7/26/2024

• Goldilocks data before the Fed meets Wednesday
• GDP at 2.8% in Q2, thanks to strong consumer spending
• A brief overview of the Tax Cuts and Jobs Act

A CITY DIFFERENT TAKE

Core PCE for June increased by 0.2%, demonstrating that we have truly entered a Goldilocks scenario for the Federal Reserve. From the Fed’s perspective this is not hot enough to raise rates, but the true question is it cold enough to cut rates?

Data has shown that we are making good progress toward cooling inflation and stabilizing labor market conditions. Urgency to cut rates would have been a bad thing. It would signify a great miscalculation on the part of the Fed or a black swan event that would lead to rate cuts.

The quality of data gives the Federal Reserve the luxury to act with patience and in a measured fashion. The Fed meets July 30–31. What do we expect from the Fed this week? An emphasis on data dependency and (most likely) a signal of September rate cuts to be on the table. The markets have priced close to a 100% probability of a September rate cut. The current dot plot shows nine rate cuts priced by 2026. There is no doubt that this would lead to a deep cutting cycle.

We at City Different still think that data dependence will continue to lead the Fed. We don’t think that every meeting will be a cut. The Fed still must thread the needle and navigate these rate cuts appropriately in every meeting.

Second-quarter GDP shows the U.S. economy growing at the rate of 2.8%. The consumer continues to remain strong due to the labor market. This was reflected in consumer spending on goods but moderation in spending on services. Real estate has been an area of weakness. The slowdown in residential investments is likely to continue, given the reductions in housing starts.

CHANGES IN RATES

Treasury yields were lower over the week. The anticipation of a September rate cut is growing. Evidence of this anticipation can be found in the two-year and 10-year Treasury curve. That spread finished the week at -0.18%; one month ago, it was -0.36%. For a little context, since September 1994, the average spread has been +0.97%. the max spread was +2.89% with a minimum spread of -1.06%. What a long way the market has come.

Municipal yields were marginally lower last week, closer to unchanged. In addition, the yield curve continued to steepen. The yield spread for a one-year to 10-year AAA Municipal GO bond went from -0.15% on July 19 to -0.12% on July 26th. Again, for a little context, since June 1994, the average spread has been +1.51%. The max spread was +3.20%, with a minimum spread of -0.71%. We repeat: what a long way the market has come.

Municipals, as measured as a ratio versus their Treasury equivalent maturities, were marginally mixed over the week.

Corporate yields were mostly lower over the week.

THIS WEEK IN WASHINGTON

What does a Trump presidency or a Harris presidency mean for the United States?

With fewer than 100 days before the election, market pundits are overflowing with prognoses.

For municipal bonds, we believe that the market has survived tax-exemption advantages under both political parties. Outstanding tax-exempt debt for Republican-leaning states is close to $1.2 trillion compared to $2 trillion in Democratic-leaning states.

The Tax Cuts and Jobs Act, signed into law under President Trump, expires after 2025. It lowered individual rates. Without renewal, the top marginal tax rate returns to 39.6% from the current top rate of 37%. This also affects other brackets. TCJA made temporary adjustments to standard deductions and estate taxes. However, the bill was not beneficial for mortgage interest. That should improve once the TCJA expires since the bill lowered the cap on deductible interest. Even though all the individual tax provisions are temporary, this bill permanently created a single corporate tax rate of 21%, eliminating corporate alternative minimum taxes.

The Biden-Harris re-election campaign once signaled support for extending most of the individual tax cuts. We are assuming that the Harris campaign will continue the same policies from before. More information about tax policies should be fleshed out over the next few months.

In other campaign news, the Harris campaign is busy narrowing down vice president picks, with Arizona Senator Mark Kelly leading the pack. Meanwhile, the Republican vice presidential nominee is generating controversies, which we won’t repeat in this publication.

WHAT, ME WORRY ABOUT INFLATION?

The 5-year Breakeven Inflation Rate finished the week of July 26 at 2.41%, lower by five basis points from the close of July 19. The 10-year breakeven inflation rate finished the week at 2.27%, also five basis points lower than the close of July 19.

MUNICIPAL CREDIT

As of July 26, 10-year quality spreads (AAA vs. BBB) were 0.98%, seven basis points lower than the July 19 reading (based on our calculations). The long-term average is 1.70%.

Quality spreads in the taxable market are not attractive. They ended the week three basis points higher at 0.78%. High-yield quality spreads were two basis points higher at 2.93%.

WHERE ARE FIXED-INCOME INVESTORS PUTTING THEIR CASH?

Money Market Flows (millions of dollars)

Money market funds saw lower cash flows this week. Is this the beginning of a pull back in money market flows in anticipation of Fed rate cuts?

Mutual Fund Flows (millions of dollars)

Bond fund categories saw mostly increased cash flows, except for the Government category.

ETF Fund Flows (millions of dollars)

ETF asset classes experienced increased cash flows overall.

SUPPLY OF NEW ISSUE MUNICIPAL BONDS

The supply of new issues is expected to be about $6.3 billion this week, a break from the continuing heavy tax-exempt supply.

CONCLUSION

The U.S. economy is strong, propped up by consumer spending. And the Fed now seems to have just what it wished for — a Goldilocks scenario. The July Fed meeting is predicated to remain more of a communication piece with potential signals of a September rate cut. However, every meeting from now on will have to be a balancing act between a cut or a no-cut scenario.

IMPORTANT DISCLOSURES
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